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Core Laboratories' Oil Market View: It's Going to Get Worse, but It Will Get Better

Core Labs believes a recovery is coming to the oil markets in the second half of 2016, but first we must get through an ugly first quarter.

After listening in to Core Laboratories' (NYSE: CLB) Q4 earnings call, I have some good news and some bad news for oil and gas investors. Which would you prefer first?

Since bad news in the oil industry is something that investors in this sector are accustomed to as of late, let's start with that.

The bad news: The near term is uglyCore Labs is one of the finest businesses you're ever going to find. The business requires very little capital investment and gushes cash, which can be returned to shareholders in the form of dividends and share repurchases.

All you really need to know about Core Labs is in the following chart. Relative to its energy sector peers, Core Labs' return on invested capital is off the charts.

Source: Core Labs corporate presentation.

What that chart tells you is that in 2014, on all of the equity that has ever been invested and retained in the Core Labs business, the company earned a return of almost 60%.

Yet in this environment, even the best businesses are hurting. Year-on-year fourth-quarter net income for Core dropped by 77%.

Source: Core Labs Q4 earnings release.

While the Reservoir Description business segment has held up reasonably well, with Q4 operating income down 23% year on year, the Production Enhancement and Reservoir Management segments are down by 84% and 62%, respectively. That is a major "ouch," and it's going to get worse before it gets better.

In its Q4 earnings release, Core predicted that Q1 2016 revenue would be down another 10% from Q4 2015's already depressed levels as the entire industry further cuts spending.

While Core's business is down in a major way year on year, it's still in much better shape than most of the industry. In Q1, Core believes that it will still generate free cash flow and fully fund its dividend.

The good news: Looking out six months is much betterNow the good news. Core Labs believes that we're at the bottom and that the second half of 2016 will finally see a recovery begin.

Core believes that the combination of a 900,000-barrel-per-day year-on-year decline in U.S. production and a 1.2 million-barrel-per-day increase in global oil demand will drive oil prices higher in the second half.

That's a view that Schlumberger (NYSE: SLB) more or less shared in its year-end conference call. Schlumberger sees a continued tightening in the oil market driven by solid demand growth and weakening supply. The company believes shale oil production is steadily declining and that dramatic spending cuts are taking effect elsewhere.

Schlumberger also made a notable observation on the apparent resilience in production outside OPEC and North America. The services giant believes that having producers open the taps wide open to maximize short-term cash flow is going to result in higher production decline rates after these short-term actions are exhausted.

The decline rate is something Core Labs also spoke to in its Q4 release -- it also believes that decline rates are creeping higher. Core has increased its estimate of the global production decline curve from 2.5% to 3.1%. That might not sound like much, but on 96 million barrels per day of production, it adds up. A 60-basis-point increase in the decline curve eliminates another 576,000 barrels of production that the world thought we thought we had coming.

That alone will offset all of the expected increase from Iran that most experts believe is coming. In January Bloomberg reported an expected Iranian production increase that ranged from 255,000 barrels per day on the low end to 600,000 barrels per day on the high end.

The bottom lineIt's been a long and painful road, but maybe, just maybe, there's a light at the end of the tunnel for the oil industry. If Core Labs and Schlumberger are correct, we're at the very bottom of a "V"-shaped boom and bust right now.